I am sure that Starbucks did not expect to face a $2.8bn settlement when they decided to terminate their distribution agreement with Kraft. In their minds, there had been ‘material breach’ – and indeed, based on subsequent performance, it does appear that Kraft was not doing a great job.
But this case study shows the importance of being clear about business objectives and, in any long-term agreement, the need to periodically review and update them. It also illustrates a need for effective governance and performance management principles and clarity over their enforcement, as well as the extent to which they contribute to ‘materialism’.
There is an excellent summary of this recent dispute in a recent edition of Inside Counsel and it can be accessed here. Of course, it is easy to point to issues with contract drafting, or perhaps the judgment that led to unilateral termination (always a risky decision). But in the end, was it really legal issues at fault, or the absence of adequate contract and relationship management? Why did issues either build up or fester in such a way that the communications between the respective CEOs became so hostile? was there a robust contract and performance management regime and if so, was it followed?
The legal issues around material breach and rights to terminate are critically important, but it is the operational aspects of the relationship that will determine whether issues are resolved amicably. Contracts provide the framework and good contract management ensures that framework is followed, and also that it is updated and maintained. it also ensures that problems are identified early, addressed collaboratively and, when necessary, escalated to relevant executives in a timely manner.
i have no idea how much this was happening at Starbucks or Kraft. But at least for Starbucks, it has been an expensive lesson.
At this week’s IACCM workshop in Sydney, Morag Lokan (Assistant Commissioner at the Australian Taxation Office) presented her thoughts on the role of relationships in contract management.
Among her charts, she set out a list of factors to be considered when evaluating the potential nature and depth of the relationship. I have expanded these slightly, to produce a set of ten.
- What is the likely duration of the contract?
- How many organizations and stakeholders are involved?
- Does your organizations speak with one voice?
- Have the suppliers worked together before (and with what result)?
- Have the suppliers worked with your organization before?
- Are they competitors?
- How important is the contract to your organization?
- How committed is your organization to making this work?
- How committed are the suppliers to making this work?
- Is there evidence of relational capability?
Last week I wrote about the growing debate over supplier integrity versus buyer competence – and the suggestion that if a buyer lacks contract management skills, they should not engage in complex contracting. (See original post here).
The issue has hit the headlines because of accusations of supplier fraud – deliberate overcharging of customers. This appears to have become more endemic as the world moves to outcome and output based contracts, with more complex charging formulas than a straightforward purchase agreement.
Anyone who has read this blog over the last 5 years will not be surprised that the absence of investment in contract and commercial skills has resulted in major problems. Trading conditions have become more complex; many organizations have adopted new acquisition or delivery models; markets have become more volatile. Yet while IACCM research has revealed that executives recognize the need for enhanced commercial capability, this has rarely translated to major improvement or change.
So what should be done? Two immediate ideas for improvement are:
- Capability maturity assessments. Already, many buyers require that their suppliers are audited for regulatory compliance (environment, bribery and corruption, labor practices etc). Often these are conducted by third parties. Assessments of commercial and contract capability could be the basis for supplier selection – or indeed of selection of customers by suppliers, since integrity in this field goes in both directions.
- Relational contracts. The principles underlying ‘relational contracting’ are focused on improved partner selection (pre-award) and governance and performance management (post-award). By clearly defining the mechanisms through which these occur, relational principles not only ensure insight to capabilities, but also create a framework for shared operational management.
Many organizations have been slow to grasp the fundamental impacts of a switch from traditional input-based buying to the more complex environment of procuring outputs and outcomes. The reaction of many has been to boost procurement practices that focus on lowest price rather than highest value and are accompanied by aggressive risk-transfer, together with reduced loyalty to long-term suppliers. These practices have the effect of limiting competition and undermining supplier commitment to performance. It could be argued that they encourage unscrupulous behavior – though there are those who would question whether any supplier is scrupulous if they think they can get away with it.
Remember “The World Is Flat”, the best-seller by Tom Friedman that hailed a future of open competition and innovation driven by a global networked economy?
Just how true have those forecasts proved to be? For a brief period, we certainly saw aggressive action on input prices as low cost economies provided multiple opportunities to outsource or offshore both manufacturing and a wide array of services. Procurement practices evolved around the theory of endless competition, placing most suppliers in a defensive position as they fought to maintain margins and market share.
Yet ironically, while global markets have clearly produced some new suppliers, in many industries the level of competition seems to have dropped. Innovation, consolidation, altered levels of dependency, increased teaming – these are among the factors that have led to shifts in buyer / supplier power in industries such as oil and gas, automotive and pharmaceuticals.
But what about the IT industry?
The UK’s National Audit Office has issued a damning report on the state of contract management in the outsourcing industry, questioning the integrity of suppliers and suggesting a lack of competence in Government departments to manage such relationships.
Given the findings and observations of the NAO and recent investigations by the UK Public Accounts committee, what steps should suppliers and customers be taking to raise the quality and integrity of contract performance? It is clear that obligations and commitments need more rigorous analysis, both in terms of capability to deliver and in actual delivery. But is this a shared responsibility, or does the burden fall disproportionately on one party? And within this, where does organizational and operational responsibility for ‘due diligence’ lie; for example, should highly trained contract managers be more directly responsible for signing off against commitments and the oversight of internal integrity? Given their operational role, might this be more effective than oversight by risk or audit functions, which tend to report after the fact?
It would be a mistake to see this as a problem that is peculiar to the UK. Repeated issues in the US (where there is supposed contract management rigor) suggest similar challenges. And the experience of many private sector firms has in truth not been much different.
Until these issues are resolved, publications such as the Financial Times suggest that organizations should not enter into complex contracts where they do not have the capabilities for their management. But is it management that is the problem, or is it the selection criteria? In other words, an organization that lacks contract management competence probably does not understand its value and therefore does not look for this quality in its suppliers. Indeed, suppliers with strong contract management discipline are quite likely to lose a competitive tender because a) they will be more conservative in the commitments they make and b) they are likely to bid a higher price. The reasons for this are that a strong contracts or commercial function acts as a constraint on the natural over-optimism of Sales and senior management; and such organizations generally do not follow a model of ‘bid low and make up margin later’. This latter attitude, induced by price-based supplier selection, leads to low levels of supplier integrity, which include aggressive pursuit of claims and a readiness to deliberately over-charge.
But does this mean that for complex relationships to work, both parties must have equal competence in contract management? I think the answer is no; but the weaker party must certainly appreciate their potential exposure and select and manage their trading partners accordingly. Processes that are driven by a conjunction of price-based procurement and risk-allocating contracts is clearly not adequate – and may even drive the opportunistic behavior that is evident in some suppliers.
Tomorrow, I will suggest some mechanisms that might address these problems.
There is an increasing number of examples of Government driving more localized procurement. It is a natural step in revitalizing local economies and, of course, in improving the tax base. Just one of those examples is illustrated by the apparent success story of Plymouth council, in the UK. IACCM’s recent edition of Contracting Excellence contained another, based on initiatives by the Scottish Government.
But the trend is not limited to the public sector. A growing number of private sector firms have learnt that the global supply chain is not all it is cracked up to be. Yes, it may yield short-term price reductions, but at what longer term cost? It is not just that there are incremental risks to consider, it is also the overall cost of building and maintaining long distance relationships. Supply consolidation faces similar challenges. For all that suppliers would like to deliver equivalent levels of service and support in every location, they frequently do not. The fact that they may be a wonderful supplier in Texas does not necessarily mean they are so great in Kazakhstan – or even in New Jersey, if it comes to that.
Quiet what the eventual local / global balance turns out to be is far from clear, but I suspect we are only at the beginning of a re-balancing, where both globalization and centralization will diminish and more sophisticated technologies will enable central controls and insight, without requiring central mandates and single-source buying.
Many organizations struggle to measure the value of contract and commercial management. That is often because they don’t ask the right questions or look in the right places.
IACCM has undertaken extensive research to understand the contribution from contract and commercial management. It takes two forms: one is the potential for value-add (e.g. through contract growth, commercial innovation, competitive differentiation of commercial terms). The other is through safeguarding against value-loss – that is failure to achieve expected revenue or margin, or to achieve anticipated cost reductions or savings. The latter is much easier to measure than the former, but it demands that organizations undertake some form of contract audit in order to identify recurrent issues that are leading to ‘value leakage’.
Based on IACCM’s analysis (and supported by a number of audits), here are the Top Ten weaknesses in the contracting process – the things you should be checking and safeguarding if you want to deliver better results. You can listen to a more detailed explanation in this podcast, or contact IACCM for a soon to be published white paper that describes best practices in these areas.
- Ensure that bid evaluation criteria reflect business need and priorities, including adequately validated technical and commercial requirements
- Select contract model and terms that match business goals and drive the right relationship / behaviours
- Avoid commencement of work without contract – or ensure appropriate controls are in place
- Watch out for over-commitment – incorrect estimates of contract value, overstatement of capabilities
- Check that key terms have been included, based on risk analysis and reference to relevant contract templates / models
- Validate scope / Statement of Work – is it complete, is it realistic, can it be fully defined?
- Harmonise contract content – avoid conflicts from poorly drafted appendices, statements of work, service level agreements etc .
- Address weaknesses in post-award contract management: ensure obligations are actively managed, review controls over change management, adequate performance criteria and / defined performance management regime, appropriate performance metrics.
- Review financial controls – e.g. drafting or management of payment schedules, enforcing price escalation or reduction terms, controls over discounting / goodwill
- Ensure thorough warranty management